How Stock Options Work https://www.stanford.edu/class/e145/2008_winter/materials/sto...
How Stock Options Work
Employee stock-option programs are typically authorized by a
company's board of directors (and have historically been approved
by the shareholders) and give the company discretion to award
options to employees equal to a certain percentage of the company's
Options give employees the right to buy a certain number of their
company's shares at a ﬁxed price for a certain period of time, usually
That price, usually the market price of the stock on the date the
options are granted, is called the "strike price."
Options usually begin vesting after one year and vest fully after four
years. If an employee leaves the company before his or her options
vest, they are canceled.
Once an option is vested, the employee can then "exercise" it--that is,
purchase from the company the allotted number of shares at the
strike price--and then either hold the stock or sell it on the open
The difference between the strike price and the market price of the
shares at the time the option is exercised is the employee's gain in the
value of the shares.
When the option's strike price exceeds the market price of the stock,
the option is technically worthless, or "under water."
When the market price of the stock exceeds the strike price of the
vested option, the option has value, or is "in the money."
When an employee exercises an option, the company must issue a
new share of stock that can be publicly traded. While the employee
pays the company the strike price for that share, the company's
market capitalization grows by the market price of that share.
Having more shares outstanding dilutes (or reduces) earnings per
share--and thus the value of shares held by investors who already
own the stock.
To forestall dilution, one of two things must happen: earnings must
increase commensurate with the increase in outstanding shares, or the
company must repurchase shares on the open market to reduce the
number of outstanding shares.
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